Those low interest rates are very high by world standards

There are many economic myths around. There is the idea that the government abolished boom and bust. There is Labour latest fashion that borrowing and spending more in the public sector produces a stronger recovery. So far the biggest borrowing nation of all the major economies, the UK, is the only one not to have pulled out of recession. My favourite today is that we have record low rates of interest which will see us through the crisis.

It is true that the Bank of England’s MPC has set 0.5% as the interest rate. The problem is the markets don’t think that is a realistic rate for normal commercial transactions, so it does not operate in the private sector.

If you want a mortgage and are lucky enough to be able to get one, you will be paying 4-5%. That’s eight to ten times the Bank’s low base rate – not just the odd 1% over to allow the Building Society a profit.

If you are a small business wanting to borrow, you will be paying 7-15% for an overdraft if you can secure one. That’s fourteen to thirty times base rate.

If you are a large business wanting to borrow from the corporate bond market you will be paying between 6% and say 10% depending on your balance sheet and trading strength. That’s twelve to twenty times base rate.

And if you are the government wanting to borrrow for ten or more years you will be paying 4% to 4.5%, or eight to nine times Base rate.

So what’s the point of Base rate? It gives the MPC something to do to set it and to justify their large salaries. It does have two impacts on the economy. It does allow the government to borrow for the short term at a lower rate. So far markets have gone along with lending for a few months or even a year or two to the government at low rates related to the base rate. Recent weeks have seen increases in the rates they charge the government for anything other than the short term.

It also helps the broken banks make a small fortune. All the time they can borrow short in the money markets and with government help at rates related to Base rate, and lend longer at rates totally unconnected to base rate, they can make more money. Given the way the banks are regulated, with the regulators shutting the stable door after the horse of excess credit has bolted, that does not help the rest of the economy as much as we would like.

UK official rates are too low for the state of the public finances.They are also largely irrelevant to the state of the non bank economy, as no-one can borrow at anything like them.

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28 Comments

  1. JimF
    Posted January 9, 2010 at 10:10 am | Permalink

    And looking at the mirror image, as a saver the rock (no pun intended) is to lend short to the Banks/HMG at pretty well 0%, with the opportunity to move out of GBP before calamity strikes. The hard place is lending long at about 3% after tax, with the threat of devaluation wiping out a year or two's returns in a day, and with all indicators pointing up for interest rates.

    This is a GBP saver's nightmare, and I think many people with significant resources will be elsewhere, in assets, other currencies.

    Very unfair on old folks and others living on savings in the UK, as they will likely be lending short and the Banks will be lending that money out, as you say, at overdraft rates of 15%. But then Labour were never really there for the poor but self-reliant, were they?

    The Conservatives should really be pressing these sorts of messages home, rather than wittering on and getting tied up with married couple allowances and all the complications therein. It is a minefield; we will have some people saying that 4 wives are better than 1 in bringing up a family, so why can't they have 5 lots of tax allowances, or whatever!

    • Eotvos
      Posted January 9, 2010 at 8:22 pm | Permalink

      Jim, I posted this question to you yesterday: –

      Jim, why should the ECB prop Sterling? I cannot think of a reason, political or economical. They’re not going to prop Greece or the Irish and they are Eurozone.

      Soros made money by selling it prior to Black Wed.

      I'd be interested in your answer.

  2. alan jutson
    Posted January 9, 2010 at 10:14 am | Permalink

    John.
    Your comment that it also helps the Banks make a small fortune is the one that carries the most weight for this low rate.

    It helps to mend their broken finances quicker.
    Yes it does, and it means those Banks who were not in trouble, make huge profits from what to most of us seems like a Cartel, for which other industries with a similar arrangement between themselves, would be heavily fined.

    Once again it seems its one rule for some organisations, and another for everyone else.

    • Sally C.
      Posted January 9, 2010 at 3:21 pm | Permalink

      This is so true. Bankers may complain about the windfall tax on their bonuses but they would not be able to make such large profits if they were not borrowing money so cheaply from the B of E. The rest of the economy is at a clear disadvantage relative to the banks. Companies have a real incentive either to buy a bank or become a bank. If I could buy a small bank, like Richard Branson, I would seriously consider it.

  3. Peter Turner
    Posted January 9, 2010 at 11:12 am | Permalink

    When is some consideration to be given to those who worked hard and saved for their retirement? At the moment the return on their savings is related to the base rate, closely related i.e. minimal.

    • Michael Lewis
      Posted January 9, 2010 at 6:28 pm | Permalink

      Agree. Thankfully I've a 30 years or so until I retire (hopefully), but people relying off income are being robbed, by Gordon Brown, to allow those that took out huge mortgages to keep their houses, to keep residential housing inflated. Ultimately, I guess both parties would want to do that: or at least keep low, steady growth. Can't continue though, has to pop sometime or another.

  4. Brian Tomkinson
    Posted January 9, 2010 at 11:26 am | Permalink

    John,
    You have so much to say on so many issues and yet your party has so little – why?

    • Mike Stallard
      Posted January 9, 2010 at 6:06 pm | Permalink

      I have often wondered this myself.
      I think there are just two problems: 1. You have to be photogenic on TV, the internet and the Red Tops. This isn't a Conservative problem only. Frank Field and Charles Clarke, two of the best minds in the Labour party have also been sidelined.
      2. When a younger clique gets into power, the oldies get thrown out. Sad, but then politics isn't a happy camp really anywhere.
      If only…..

  5. Richard
    Posted January 9, 2010 at 11:33 am | Permalink

    Good point. Another economic myth, repeated daily in the media by Labour supporters, is that Brown 'did the right thing' and the Conservatives were completely 'wrong' over the bank rescues. It is asserted that there is global recognition that Brown's policy prevented the world falling into a depression. Of course this is complete rubbish as readers of this site will understand. Unfortunately, official Conservative spokesmen are not particularly robust on this issue. We need to highlight better that the equity which has gone into the banks has gone – the equity would be worthless without the government guarantees. No doubt there are foreign governments who are pleased that Mr Brown imposed the whole cost of the bank rescues on UK taxpayers rather than insisting on balance sheet restructurings which would have imposed losses on banks and investors in other countries. The public needs to understand 1) that Labour has wasted prodigious amounts of public money in the bank rescues; 2) that the equity has gone and can never be recovered (it couldn't be sold and the state guarantees removed) and 3) the resulting oligopilistic banking market and distorted interest rate policy is a hindrance and not a help to economic recovery.

  6. Denis Cooper
    Posted January 9, 2010 at 11:41 am | Permalink
  7. Mark Cooper
    Posted January 9, 2010 at 12:49 pm | Permalink

    John,
    To state the obvious from A level Economic:

    lower rates cause a devaluation of a currency because foreign investors take their cash elsewhere.

    The low rate devalues the GB£ against other currencies.

    This makes exports more competitive overseas, and imports less attractive to UK residents so they buy local products.

    It also encourages people with savings to spend their money, since the actual interest they earn is less than or close to, the rate of inflation so there is no point in saving. People spending their money instead of saving encourage economic activity.

    While I detest the current government, I don't think they have any option but to have this very low rate.

    There are several other things they could do to improve the economic situation, not just spending cuts and tax increases. It beggars belief that they spend thousands of man days working on legislation like IR35, family allowance etc, but cannot come up with simple incentives for business growth, or simple incentives to force banks to lend- I can think of a dozen ideas like car scrappage that would help.

    • Stuart Fairney
      Posted January 9, 2010 at 5:06 pm | Permalink

      They have the option not to have a rate at all of course. Government doesn't set the price of bread, why should it set the price of money? Just sack the MPC and leave it to the market.

    • Ian Jones
      Posted January 10, 2010 at 9:13 am | Permalink

      Devaluing your way to competitiveness. One of the key reasons for making the Bank of England independent was to keep inflation low to ensure we remained competitive without having to devalue.

      Short run it works but in the long run, investors will demand a much higher rate of return to invest in the UK as there is the risk of seeing their capital devalued away.

      With these low interest rates and especially QE, they have blown their credibility out of the water. This means higher interest rates in the future, lower growth and lower standards of living.

      The Bank of England failed in its primary task.

    • waramess
      Posted January 10, 2010 at 11:40 am | Permalink

      Devaluation makes us all take a pay cut, and that is what has happened; it cannot make a difference through exports when our manufacturing is at such a low ebb.

      More devaluations as predicted will simply mean more pay cuts. Maybe when we are all on a bowl of rice a day we will become competitive with the Chinese, but I suspect with the disincentives to industry currently in place, it will not happen any time soon.

      Once again we are all following the Americans with interest rates and so long as the Americans can get their new treasuries away at these rates then our rates will remain there also… unless there is a gilts strike

  8. Stronghold Barricade
    Posted January 9, 2010 at 1:44 pm | Permalink

    Again, on the banks

    As well as the profits, there has been a major reduction in competition with the withdrawal of some, bankruptcy of others, zombification of more

    The winners are those who survived, and are benefiting from this government's policy

    The triumvirate are probably just counting their salaries and wondering what bonuses they can screw from the system before the election

  9. Brigham
    Posted January 9, 2010 at 1:54 pm | Permalink

    This is only slightly on subject, but I wanted to get your view on something I read recently. Cameron is giving Brown a soft time at PMQ's because, with Brown leading the labour party, the tories will get many more seats than they would with anyone else.

    Reply: I don't think he is giving him a soft time, but Mr B suits the Tories

  10. Kevin Peat
    Posted January 9, 2010 at 2:45 pm | Permalink

    I'd certainly vote for you, Mr Redwood.

    Now let's not forget real inflation either. This has been rising inexorably for years. How so ? Well house prices for a start – how convenient that they have been left out of calculations (regardless of recent dips.)

    I'm more concerned with the day-to-day inflation that we are seeing introduced by stealth: biscuit packets being reduced in weight sneakily, thinner matches which break more frequently, lightbulbs that pop after six months, sticky tape that snaps, meat that cooks down to nothing because it's so pumped up with water…

  11. Mike
    Posted January 9, 2010 at 6:14 pm | Permalink

    John

    Let's have a savers charter. Link returns to the rate that the 'house' is charging for loans. It would make for clearer and cleaner 'products' in the loans and mortgage market.
    Why should there be such a huge discrepancy? The banks are playing on the savers fears that their savaings are at risk.
    National savings returns on investment are a disgrace.

  12. Mike Stallard
    Posted January 9, 2010 at 6:19 pm | Permalink

    Do you know what?
    I am HEARTILY SICK of watching my family's life savings, being used to prop up the government's careless financial incontinence for almost anything they happen to approve of.
    And nobody seems to have noticed, except our host.
    What happened to the "toxic debts"? Is this the way they are being secretly paid off?
    Mr Brown is currently on his high horse about Iceland. We are still Bejam. Iceland, for us, comes later. I just hope that the Germans, IMF and Americans will not treat us as rudely as we have treated Iceland this week.

    PS I was delighted to read that RBS is selling some bits off.

  13. no one
    Posted January 9, 2010 at 9:53 pm | Permalink

    the state has centralised the distribution of salt to cope with a week of snow. Prudent local authorities, who ensured they'd be prepared for a tough winter, are in effect having their salt supplies requisitioned to provide for those who failed to do likewise.

    Local accountability? Why would a town hall ever try to take the initiative itself and plan ahead for the unforeseen if central government is going to wade in whatever? Why use your initiative to help out your neighbouring authority, if a 'phone call from Whitehall is going to dictate the relationship anyhow?

    from Douglas Carswells blog is a great post!

  14. Javelin
    Posted January 9, 2010 at 9:55 pm | Permalink

    Been saying for years the remit of the BofE MPC must include house prices. This is true even now.

    Whilst you can only get a mortgage for 4-5% alot of mortgage payers on trackers are paying 1-2%. This creates a huge number of mortgage payers who cannot justify to move house. Reducing supply of houses in the Market falsely raises prices. When rates do rise it will create a surge of pent up supply. The longer the low interest rates go on the further the bow string will draw back.

  15. TD
    Posted January 9, 2010 at 10:16 pm | Permalink

    To be fair to the banks, you can't compare short rates and long rates as directly as John has in this article.

    Sure, a bank will borrow short to lend long. However, there are 3 things to note;

    1. The short borrowing has to be rolled every three months for however llong the lending might be for (lets say 10 years). Given no-one knows the path of rates, there is significant re-investment risk.

    2. Long rates are set by the market – specifically Gilts and interest rate swaps. Credit default swaps will also affect loans to business. They are not directly tied to short rates at all.

    3. Banks record profits on a mark-to-market basis. Therefore, the act of lending long and borrowing short in itself makes no money (though the spreads they charge on top to the customer might be).

    The problem really revolves (certainly this is partly the cause of the credit crunch) around too much leverage in the long end of the market. Too many people trying to borrow long term (mortgages as well as governments and corporates) with too high gearing. Against that the banks were all trying to borrow short to fund it. When short term funding became a problem the system came close to collapse.

  16. Robert
    Posted January 9, 2010 at 10:32 pm | Permalink

    John, all sensible stuff as I would expect from you. I would like to point out that this was exactly my arguement 12 months ago when I indicated that cutting base rates would not reflect the real cost of borrowing as the market would set the true cost of borrowing which as ever would result in those people who had been thrifty being penalised to support the feckless. By this I mean that those with money on depost would get very much lower returns and for a majority being forced to seek higher returns is not necessarily appropiate for their stage in life! It is ironic that if you do the right thing you get penalised yet again by Government.

  17. Lindsay McDougall
    Posted January 10, 2010 at 2:34 am | Permalink

    So is it true, therefore, that if the Base rate was raised from 0.5% to (say) 3% quickly, the effects would be benign?

    • alan jutson
      Posted January 10, 2010 at 11:38 am | Permalink

      Lindsay

      You Know the answer to your own question.

      Rates would go up to protect the Banks inflated margins, because they have seen they can get away with it.

      All that has happened in this Credit Crunch is that the Banks have increased their margins by about 300%, whilst those businesses who are having to borrow money from those Banks, are seeing their margins reduce as their overheads increase due to higher charges.

      • Lindsay McDougall
        Posted January 10, 2010 at 11:04 pm | Permalink

        I don't think that banks' lending rates would go up to match a rise in base rate from 0.5% to 3.0%. I believe that 0.5% is so low that the private sector is ignoring it. John Redwood's comment that the low base rate allows the broken banks to make a small fortune suggests that he agrees – see his penultimate paragraph.

        I have a CAT mortgage at Base Rate + 1%, so from a personal point of view I am happy with an 0.5% base rate. However, it is very likely to be inflationary. There is something to be said for monetary policy being a little bit loose while the fiscal deficit is being cut. The problem is that it is being overdone and Labour isn't cutting the deficit.

        • alan jutson
          Posted January 11, 2010 at 7:40 pm | Permalink

          Lindsay

          I still think the Banks will increase rates when the Bank rate goes up.

          You negotiated well, as did my Daughter for her mortgage to follow the basre rate.

          But, Time will tell if I am right or wrong.

  18. StevenL
    Posted January 10, 2010 at 2:11 pm | Permalink

    Doesn't the base rate affect LIBOR, which in turn affects the 3 month interbank rate which is giving the banks massive spreads to trade their way out of being insolvent?

  • About John Redwood


    John Redwood won a free place at Kent College, Canterbury, and graduated from Magdalen College Oxford. He is a Distinguished fellow of All Souls, Oxford. A businessman by background, he has set up an investment management business, was both executive and non executive chairman of a quoted industrial PLC, and chaired a manufacturing company with factories in Birmingham, Chicago, India and China. He is the MP for Wokingham, first elected in 1987.

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